We’re boosting our fair value estimate of Kinder Morgan as the firm’s new structure removes the burden of incentive distributions and will likely support 10% annual dividend growth, says Morningstar’s Jason Stevens.
We are raising our fair value estimate for Kinder Morgan (KMI) following the announcement of a plan to consolidate Kinder Morgan Energy Partners , Kinder Morgan Management , and El Paso Pipeline Partners into a single corporation. As we indicated in our last note, this consolidation removes the burden of incentive distributions, which weighed on distribution growth to limited partners at KMP, and sets up a structure we believe is likely to support 10% annual dividend growth at KMI. This pace of dividend growth is higher than we had anticipated, supporting our new $40 fair value estimate for KMI. We think it is exceedingly likely this transaction will close by year-end.
Under the terms of the deal, unitholders of KMP will receive $10.77 cash and 2.1931 shares of KMI for each unit owned, valuing KMP at $98.50 at our $40 fair value for KMI. Unitholders of EPB will receive $4.65 cash and 0.951 shares of KMI for each unit owned, valuing EPB at $42.45. Shareholders of KMR will receive 2.4849 shares of KMI for each share of KMR, equating to $99.40 at our $40 fair value of KMI. Interestingly, due to the cash and stock compensation offered KMP unitholders versus the pure stock compensation for KMR shareholders, the math works out in favor of KMR owners when KMI's stock price is above $37 per share; at our $40 per share estimate, the deal values shares of KMR $0.90 higher than equivalent units of KMP.
KMR shareholders have another advantage. Because this is a stock-for-stock transaction, the deal is not a taxable event for KMR owners. In contrast, most unitholders of KMP and EPB are in for a taxable event in calendar 2014. Ownership of master limited partnerships is complex but offers tax advantages, as MLPs are pass-through entities from a tax perspective. This means that unitholders receive their pro rata share of allocated income and depreciation that they must account for in their personal (or corporate) taxes. However, due to high levels of depreciation there's also an effective tax deferral for taxable ordinary income. The merger ends that deferral, and individual owners' tax bills will come due this year.
Income investors may also have cause for frustration, as the nearly $6 of cash distributions they may have expected in 2015 will now come in the form of a $2 dividend times the exchange ratio, or $4.39 per KMP unit owned today, reflecting a 25% decrease in cash income. EPB unitholders face a 27% cash income decrease. The offset is that KMI dividends will grow about twice as fast as KMP's distributions and 3 times faster than EPB's. From our vantage, we think the merger offers a compelling proposition and expect KMI shares to appreciate faster than either MLP would have without the deal, but we acknowledge that this is a total return, and not an income, viewpoint.
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